The Power of Compound Interest

Those who understand compound interest… earn it. Those who do not understand it… pay it.

If you’re in the first camp, read on for some Good Stuff. If you’re in the second camp… let’s shift you into the first camp 😄

What Is Compound Interest… and Why It’s Powerful

The biggest question people have when it comes to finances and planning is usually: How quickly will my money grow? How long will it take until I double the money that I have now? 🤔

How much your money grows depends on the interest rate you’re earning. After all, earning interest is “free” money! If you have to save $100,000 by yourself… that might take a while. But if you can save $10,000- and then earn interest over and over again on that $10,000!- you will save up to your target amount much more quickly ⏰

This happens through the magic of compound interest. Compound interest may sound complicated, but it’s easy! You probably understand it already, it’s just that no one has directly explained it to you before 😃

Compound interest is the idea that you will earn interest on your interest. For example, let’s say you have a sum of money in a savings account. The very first month you opened that savings account, you earned interest on the money in that account- that’s just called “simple interest”. So your account now holds the amount you saved, plus the interest you earned 💰➕💲

The following month, you earn interest on the full sum in your account- your savings, plus the interest you’ve already earned. You are now earning interest on your interest! That is “compound interest”. That pattern repeats itself over months and years 💰➕💲💲💲

Honestly… most of the interest accrued- in all accounts, everywhere- is compound interest. It’s only the very first iteration of interest earned that is considered “simple interest”. It works this way for your car loan, your mortgage, the interest you earn in your retirement and savings accounts; all of it- except that very first bit you earned- is compound interest.

See? You probably know that already! 😁

Now that you can define compound interest… did you know that you already know how to do the math to roughly calculate compound interest? Seriously! You do! 👍🏼

Compound Interest Works According to One Very Basic Rule

There’s a very easy rule of thumb you can use, to figure out how quickly you will double your money on an investment. It’s so easy you can calculate it in your head 😁

The rule is, divide 72 by the interest rate you’ll earn. The answer will be the number of years it will take you to double your investment. This rule holds true, no matter the amount of your investment. Let’s have an example:

Let’s say you want to know how long it will take you to double your money on a real estate investment. You know, for sure, that real estate properties will appreciate 8% per year in your area. (Denver has seen 55% appreciation over the last 5 years. That won’t last in the future- it’s already slowing down- but yikes!) 🏡

We divide 72 by your interest rate- so, 72 divided by 8- which equals 9. This means that if you buy an investment property today- and your property consistently appreciates at 8% per year- you will double the value of your investment in only 9 years 📆

So simple, you can do this math in your head 🤯

What This Means For You and Your Future

Not everyone can, or wants to, invest in real estate. Here are two more examples- one in which compound interest works for you… and one where compound interest works against you 😇👿

Have a credit card? Let’s say you have an emergency, and you have to pay for an expensive auto repair with your credit card. Your credit card charges 18% interest per year. Using the Rule of 72, your credit card balance will double every 4 years. (72 divided by 18 equals 4.) Your $2,000 car repair will grow to $4,000 in four years, $8,000 in eight years, and so on. Imagine paying that amount of money for a single car repair 😵

Side Note: This, of course, will only happen if you don’t make any payments. If you don’t make any payments, you’ll have worse problems 😖 We’ll explore how credit card balances really work in another Smart Money Minute.

Okay, whew! You were able to pay off your credit card right away, and now you have the mental energy to start saving for your retirement. Using the power of compound interest, you can earn hundreds of thousands of dollars of compound interest over your lifetime- enough to make retirement possible, comfortable, or amazing. Our second example is about making compound interest work for you- not against you 💪🏼

The powerful things about compound interest is that small changes in your interest rate will add up to large changes in your savings 💲 ➡️ 💰💰💰

Let’s say we have 29-year-old triplets, who have each inherited a sum of money from their dear, departed grandmother. Each of them has inherited $10,000; they may invest it how they choose, but they have to save their inheritance until the age of 69. We are going to see how small changes in the interest rate they earn will result in far more compound interest accruing:

The first triplet, Greg, wants a safe investment. Greg decides to put his money into a money market account. He shops around, and finds the best money market rate he can, earning 2% per year. (And, sadly, real money market rates are even lower than that! Another yikes!) 💲

The second triplet, Jeff, is a skydiving, rally-car-racing risk taker. He manages his money the way he manages his life- high risk all the way. Jeff invests in real-estate-based securities; he knows that those vary in how much they earn, but since he can’t access his earnings til he’s 69, he’s going to see how much he can make over time 📆

The last triplet, Mandy, wants to do better than that. Mandy is okay with a little financial risk, so she finds a financial advisor who will manage her inheritance for her. She has to pay some fees, but Mandy knows that over time, her financial advisor knows more than she does, and will get a better return for her over the long run 📈

When they are 69, the three triplets compare notes about how their inheritance investments did over time. They each had 40 years to earn:

Greg’s money market account advanced at a steady 2% per year. He never lost money, and his money grew to a tidy $22,000. That’s not bad! His compound interest earned him $12,000 that he never had to work for 👍🏼

Jeff was also happy with his results. As he knew, his real estate securities went up some years, and down in others, but on average, he earned 4% per year. “Haha Greg,” he teased. “I’m going to have twice as much as you do!” He looked at his account balance, and he was shocked. His 4% interest more than doubled Greg’s earnings. Jeff had accrued $48,000, and he was extremely happy with that 😁

Mandy debated telling her brothers about her earnings. She had earned a solid 6% per year, with her financial advisor’s help. After her brothers’ badgering, though, she showed them her results. Mandy had accrued a whopping $103,000! 🤑

These triplets, results, and teasing comments are entirely fictional- but the results are real. A modest increase in interest rate- only 2% per year- more than doubled the next sibling’s account balance. That is the power of compound interest, and now that you understand this power, you can make your money work for you 💪🏼

Compound interest is “free” money- it’s money you don’t have to work for- and it can vastly augment your savings and contribute to your financial future 💸

Now That’s Smart Money 🧐